What is compound interest and why should I care?

In a few words it's often described as"interest on interest".

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Compound interest is an extremely powerful force that allows your money to grow and multiply at a much faster rate than simple interest. Just to give you an example, imagine you have $1,000 invested and earning 10% per year; at the end of the first year you will have $1,100 (your initial investment of $1,000 and $100 interest). At this point you could use or spend your earned interest, or maybe keep it uninvested and start year 2 with $1,000 invested, you will again have $1,100 at the end of year 2 (your initial investment of $1,000 and $100 interest). However if you allow your interest to compound, you will be earning interest on $1,100 at beginning of year two, and by the end of year two you will have $1,210 (your initial investment of $1,000 and $210 interest). The following year you will be earning interest on $1,210. Although this may seem like a small difference at first, the chart below will illustrate how powerful compound interest can be.

For this example we will start with savings of $5,000 and use 8% average return per year (SP500 average return since inception in 1957 through 2021 is approximately 10.5%).

Individual A, has $5,000 saved on a non-interest-bearing account. Individual A saves additional $5,000 (approximately $400 per month) yearly for the next 40 years. After 40 years, individual A will have accumulated $205,000 (total principal).

Individual B, has $5,000 invested (earning 8% per year) and every year he saves the earned interest but does not reinvest it. Individual B continues to deposit $5,000 per year (approximately $400 per month) for the next 40 years. After 40 years, individual B will have accumulated $533,000 (205,000 principal and $328,000 of interest).

Individual C, has $5,000 invested (earning 8% per year) and every year all interest earned is reinvested. Individual C continues to deposit $5,000 per year (approximately $400 per month) for the next 40 years. After 40 years, thanks to the power of compound interest, individual C will have accumulated $1,403,905 ($205,000 of principal and $1,198,905 of interest).

On this example, the same amount of money will generate $328,000 of simple interest or $1,198,905 of compound interest.

It is important to point out that compound interest becomes much more powerful over time. As you can see above, the balances are relatively close by year 5, but by year 40 the separation is huge. If you are 45 years old at year zero and retire at age 65, you will be around year 20 on the graph. However if you are 25 years old at year zero and retire at age 65, then you will be around year 40 on the graph. I think this illustrates the importance of starting early or as soon as possible. If you are not reinvesting your interest and allowing it to earn "interest on interest", you should consider starting now.

Finally, please consider taking some time to teach your children and other young people around you the importance of compound interest, as it could provide great benefit to them in the future. Share your thoughts and comments!